Project Financing in Today’s Market
The Federal Reserve's initial gathering of the year is scheduled for this week, with market analysts forecasting another interest rate hike. The combined impact of last year’s rate increases, coupled with labor shortages, supply chain disruptions, and elevated material costs, has resulted in many businesses delaying capital projects indefinitely. In this climate, it is imperative for organizations to have a clear understanding of the financing options available for commercial projects.
In this article, we will delve into the most common methods of financing a commercial construction project, the differences between a commercial construction loan and a residential mortgage, how lenders determine the amount to lend for a construction project, when to start the conversation with a lender about financing, and the up-front costs involved in the process.
The most common funding source for a commercial construction project is through a loan from a bank or other financial establishment. Commercial construction loans differ from traditional mortgage loans in the way they are structured. Instead of receiving the full loan amount upfront, the loan is disbursed in stages based on the completion of certain milestones during the construction process. This type of loan structure is known as a draw schedule or draw period. The lender will release funds as the construction progresses and confirm that the work has been completed to their satisfaction with the help of an inspector.
Interest payments are only made on the funds that have been disbursed, meaning that if only a portion of the loan has been received, the borrower will only pay interest on that portion. Once the construction is completed, the full amount of the loan becomes due and can be paid off in a lump sum.
However, instead of having to make a large payment, the borrower can convert the commercial construction loan into a commercial mortgage. The property serves as collateral for the mortgage, and the funds from the mortgage can be used to pay back the construction loan. This way, the borrower is locked into more affordable monthly payments over a longer period. In this manner, commercial construction loans provide flexible financing options for businesses looking to undertake new projects.
Businesses can also ask their lender about a construction-to-permanent loan. This type of loan combines both the construction loan and the mortgage into one loan, eliminating the need to apply for two different loans. This eliminates the hassle and expense of having to apply for two separate loans, and ensures a smooth transition from the construction phase to the permanent phase of the loan.
When it comes to determining the amount to lend for a commercial project, lenders use a Loan-to-Value (LTV) ratio, which is the ratio of the loan to the value of the finished product (property and new building). The lender will start with an appraisal of the property, the construction plans, and construction estimate to determine the total value. The lender will then loan a percentage (usually 75-80%) of the total value. To be eligible for a commercial construction loan, borrowers typically need to show they have skin in the game, such as owning the land or offering another investment property as collateral.
It is important for potential borrowers to understand that the value of a property and new building can often be greater than the sum of their individual costs. For instance, if a business acquires a property for $100,000 and plans to construct a new building with a budget of $1,000,000, the combined cost would be $1,100,000. However, the entire project (property and building) may be appraised at $1,500,000. In this scenario, a loan for 80% of the total value, which amounts to $1,200,000, can fully cover both the land purchase and construction expenses. Although starting a new capital project involves inherent risks, investing in a market with high property values can result in a new development with minimal out-of-pocket expenses.
Given this information, there are some up-front costs to acquiring a construction loan that businesses should be aware of. These costs can include the loan application fee, appraisal, title insurance, and other miscellaneous expenses that may be charged by the lender for processing the loan.
In addition to the fees charged by the lender, businesses should also plan for the cost of complete permit drawings by a licensed design firm. On average, a complete drawing package will cost between 6-10% of the total construction costs. While design firms can offer preliminary construction budgets, due to the rapidly changing material and labor environment, it is best to consult with a licensed commercial general contractor to obtain an accurate construction estimate. Both the drawings and the estimate will be required by the lender for the appraisal.
For businesses planning projects in the next 1-5 years, it is important to have an understanding of the financing options available. It is never too early to start the conversation with a lender. For information on the financing process, please reach out to us here.